Summary

Fears of an early end to Federal Reserve (Fed) stimulus and the consequent bond market sell-off appear to be overdone.

Chairman Bernanke has made it clear that the Fed will be transparent and cautious when it begins to raise the federal funds rate; it does not want to upset the bond markets unnecessarily.

According to my analysis, yields are now at levels that should be sustainable, even if the outlook for Fed policy remains uncertain.

The first hints of Fed tightening have almost always produced an emotional and outsized sell-off in the bond markets. That appears to have happened again last week. Markets responded sharply to Chairman Bernanke’s comment that if growth improves along the path envisioned by forecasts from Federal Open Market Committee (FOMC) members, Fed bond purchases could be reduced gradually starting later this year and could end altogether by mid-2014. The markets ignored the second part of his comment—that if growth did not improve or if it weakened, the purchase program might be extended. If gross domestic product (GDP) growth is to reach the 3.0% to 3.5% range—which is what the FOMC envisions for next year—the second half of this year must show a greater improvement than the 2% pace of the first half. While that is possible, it is not a sure thing. In addition, some FOMC members are concerned that the rate of inflation (in the 1.0% to 1.5% range), as measured by the personal consumption expenditure deflator, is so low that additional stimulus might be required to prevent deflation. Thus, fears of an early end to Fed stimulus and the consequent bond market sell-off appear to be overdone.

Transparency and caution are what the Fed has promised

Since late April, yields are up by at least a percentage point in most segments of the U.S. markets. Even if the Fed were to start tightening soon, yields would probably increase more moderately, in keeping with the pattern of past cycles, which have seen an emotional sell-off at the first hint of tightening and more moderate increases thereafter. In fact, from 2004 through 2006, many yields actually declined after the initial emotional reaction to the onset of Fed tightening. The media like to recall 1994, when bonds suffered steeply negative returns once Fed tightening began. In that instance, however, tightening was aggressive, with federal funds rate increases of 50 basis points (bps; 100 bps equals 1.00%) and 75 bps that surprised the markets. Chairman Bernanke has been clear that this Fed will be transparent and cautious when it begins to raise the federal funds rate—it does not want to upset the bond markets unnecessarily.

The typical market reaction to a rise in short-term interest rates has been some degree of yield curve flattening. It is extremely unusual for bond yields to rise as much as short-term rates do. In 1994, however, yields on notes and bonds increased, even without an increase in short-term rates. Perhaps this was primarily an unwinding of what had become overbought, and in some cases frothy, conditions in many markets. The speed and severity of the correction suggests that leveraged, speculative positions were being liquidated. If so, it follows that yields are now at levels that should be sustainable, even if the outlook for Fed policy remains uncertain.

The plausibility of positive returns between now and 2016 in the corporate and municipal markets

The majority of the FOMC expects the federal funds rate to stay below 3.0% through 2015. If, therefore, we assume that it doesn’t reach 3.0% until 2016, it is plausible to suggest that the corporate and municipal markets may produce positive returns between now and 2016, based on the history of previous interest-rate cycles. If the federal funds rate were to rise to 3.0%, and the yield curve were to flatten, as it did in the majority of previous interest rate cycles, I would expect the yield on the 10-year Treasury note to be around 4.0%. Based on the same logic, I could see yields on 10-year high-yield (single B-rated) corporate notes to be around 7.0%. Those yields are already around 6.5%. Yields on A-rated 10-year municipals would probably be around 4.0%, in my estimation. Those yields are around 3.5% now.

To be sure, assumptions concerning how bond yields might react to a rise in the federal funds rate are tricky because every cycle is different. But, in every previous episode of Fed tightening that began when yield curves were steep—as they are now—those curves became much flatter as short-term rates increased. If that pattern is repeated in this cycle, the higher bond yields now in place in the corporate and municipal markets could provide sufficient income to produce positive total returns even if the federal funds rate were to increase almost three percentage points over the next three years.

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